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A 50:50 Chance

The New York Times recently published an article advocating a standard portfolio of 50 percent stocks and 50 percent bonds based upon recent analysis by Vanguard. The analysis, based upon performance data from 1926 through June 2009, suggests that this allocation seems to generate consistent returns regardless of whether the economy is in recession or expansion. Indeed, a 50:50 portfolio generated an average annual return of 7.75 percent per year during recessions and 9.9 percent per year during expansions. Factoring in inflation, the average real return (return – inflation) was 5.26 percent per year during recessions and 5.59 percent per year during expansions.

The desired inference, understandable given John Bogle’s influence and Vanguard’s commitment to passive management and indexing, is that we denigrate tactical asset management. According to an author of the analysis, quoted in the Times, “the results suggest that as investors, rather than try to time the market, most people are best off with a diversified portfolio and just sticking with it over the long run.”

Bogle, Vanguard’s now retired founder, has long advocated a 50:50 portfolio. For example, his 2001 essay, The Twelve Pillars of Wisdom, proposes the following:

There are an infinite number of strategies worse than this one: Commit, over a period of a few years, half of your assets to a stock index fund and half to a bond index fund. Ignore interim fluctuations in their net asset values. Hold your positions for as long as you live, subject only to infrequent and marginal adjustments as your circumstances change. When there are multiple solutions to a problem, choose the simplest one.

Following a dreadful decade for stocks and a 30-year rally in bonds, it should be pretty clear that a 50:50 portfolio would have been a good idea in retrospect. But given current bond yields and expected forward returns, will it make sense going forward? In other words, is the analysis an exercise in hindsight bias and recency bias?

As Geoff Considine has noted, over the past 15 years, Vanguard’s Total Bond Market Index Fund (VBMFX) has returned an average of 6.02 percent and over that same period, Vanguard’s S&P500 Index (VFINX) has returned an annualized 5.33 percent. There is thus no combination of these two index funds that can possibly generate annualized returns greater than 6 percent, which is far from the 8 percent per year that the Vanguard analysis claims by using data back to 1926. We can expect mean reversion at some point, but investors over the past fifteen years are likely to have been disappointed with this approach.

The Vanguard analysis wants to make the case for diversification as an antidote to difficult markets. While I can generally agree that broad and deep diversification is a reasonable defense against difficult markets, a 50:50 portfolio is far from well diversified — just look at the correlation numbers. As Rob Arnott points out, a portfolio that is 60 percent allocated to the S&P 500 and 40 percent allocated to a bond fund still has a 99% correlation to the S&P500.

A 50:50 portfolio just isn’t very diversified. Some other choices are necessary if diversification is the intended goal.